US treasuries: HFTs – to USTs and beyond?

It’s hardly news to anyone working in the
global government bond markets that
high-frequency traders (HFT) now account for a larger share
of secondary volume in US treasuries than traditional bank
primary dealers. The interdealer market has grown increasingly
electronic, conducted on
platforms such as BrokerTec and eSpeed, and firms like Jump
and Citadel dominate with firms like KCG not far behind. Bank
dealers, by contrast, have cut the amount of capital they
devote to trading substantially.

However, much remains unclear in US treasuries trading, not
least how much business is conducted away from the screens on a
bilateral basis between dealing banks and large asset managers,
how much of this is done by voice and how much by clicking and
trading against live prices streamed by the dealers to select
customers, who might compare several sources to comply with
requirements to transact at best price. How much of this
activity is a prelude to the assumption of net market risk that
banks may later seek to lay off electronically on BrokerTec and
eSpeed, which one banker suggests to Euromoney are merely the
secondary, secondary markets? No one can even guess.

Just because HFTs do more business on electronic market
places does not make them good providers of a customer
market-making service to real money or leveraged asset
managers. In their investigation of the flash rally in US
treasuries last October, US regulators concluded that while
HFTs commonly act as short-term liquidity providers, buying and
selling frequently in small amounts, they rarely take
significant, unhedged intraday positions and are too thinly
capitalized to end the day with much net exposure.

This
liquidity provision is prop trading by another name and is
provided primarily on the basis of immediate profitability,
rather than as a service offered in the context of existing
customer relationships that are intended to be profitable over
time.

Trading algorithms can calculate that, in the process of
filling an order, especially one requiring multiple linked buy
and sell orders in correlated markets, there are times when it
makes sense to pay the bid-offer spread and times when it is a
better strategy to rest passively and capture spread by leaving
the bid-offer open to other takers.

Wary of taking comfort

So while HFTs might show tighter bid-offer spreads than bank
dealers during the normal course of business, they are even
quicker to reduce the already small sizes in which they trade
during periods of volatility. And even if they do continue to
display tight bid-offer spreads during turbulent conditions,
other fund managers should be wary of taking comfort that they
will provide an exit route. The depth of order books may prove
very shallow.

Much of the debate around the role of HFTs has concentrated
recently on accusations of market manipulation, stuffing orders
into exchanges and electronic platforms to slow order
processing, then cancelling orders and finally using a speed
advantage to trade profitably in the aftermath.

Yet in all this something important may be being missed.
There are signs that some non-bank dealers may be at the point
of building genuine customer market-making businesses, going
beyond provision of largely inter-dealer liquidity to selling a
service to fund managers analogous to that which bank dealers
used to provide and based not just on tight spreads but also a
maintenance of firm executable prices in large size.

What are banks good at? Provision of credit to enable
trading, for example through prime brokerage certainly, perhaps
also collateral management, which is so crucial to their own
treasury departments’ funding operations and also
managing the rails of payments.

But is the old-style senior trader on the bank dealing desk
likely to have a better intuitive capacity for capturing the
information content in shifting patterns of liquidity flow and
pricing in multiple markets whose correlations with each other
wax and wane than the best algos? Probably not. And can any
large bank’s fractured systems compete with the
newcomers on speed of updating risk exposures in real time?
It’s hardly even a fair question.

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